DP9698 Regime Switches in the Risk-Return Trade-off

Author(s): Eric Ghysels, Pierre Guérin, Massimiliano Marcellino
Publication Date: October 2013
Keyword(s): conditional variance, Markov-switching, MIDAS, Risk-return trade-off
JEL(s): G10, G12
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9698

This paper deals with the estimation of the risk-return trade-off. We use a MIDAS model for the conditional variance and allow for possible switches in the risk-return relation through a Markov-switching specification. We find strong evidence for regime changes in the risk-return relation. This finding is robust to a large range of specifications. In the first regime characterized by low ex-post returns and high volatility, the risk-return relation is reversed, whereas the intuitive positive risk-return trade-off holds in the second regime. The first regime is interpreted as a "flight-to-quality" regime.